Understanding credit default swaps and why the AIG bailout was wrong

Was the AIG bailout really necessary? Maybe, but probably not. Let me explain.

Credit default swaps (CDS) can be used in two ways: 1) to insure actual mortgages or other forms of debt against non-payment, or 2) as speculative instruments, like stock options, to place bets on the condition of a specific debt obligation or the debt markets in general. Of the CDS related to the mortgage crisis, estimates are that about 10% of the CDS were used to insure actual debts, while 90% were used in speculation, where the buyer did not actually own any debt to be insured. I'll address each of these "pools" of CDS separately.

Re the 10% non-speculative pool, if you assume that all of the sub-prime mortgages originated in the past few years, $6-$7 trillion worth, had been insured with CDS (which they weren't), and that AIG had been the only insurer (which it wasn't), and that the mortgages are now worth 50%-60% of their original values, then AIG would be sitting on about $3 trillion in CDS losses. This would have aggregated all of the mortgage losses under one roof. In other words, the total CDS losses would be equal to, and could not exceed, the amount of the mortgage losses. So, on the scoreboard: mortgage losses $0; CDS losses $3 trillion. If this had been the scenario, there would have been two options. One, AIG could have been taken into bankruptcy and the holders of the mortgage obligations would have been forced to eat the losses they thought they had insured. Alternatively, the government could have decided to, and did, bail out AIG and pay off the CDS. To get the payoffs, however, the holders of the CDS are supposed to sign over their mortgage assets to AIG. If the mortgages ever increase in value, then AIG would at some later date be able to recover some of its CDS losses. So, under this scenario, all financial institutions other than AIG would remain healthy, and AIG (and the government as owner of AIG) would be sitting on a stack of mortgages, hoping and waiting for a bounce-back in housing values.

Re the 90% speculative pool, these were just bets between financial firms (i.e., Wall Street firms, insurers like AIG, hedge funds, etc.). These firms can place all the bets they want with each other, but ultimately, no money related to the bets ever leaves the financial system. This is why all the talk about an AIG collapse leading to a meltdown of the financial system doesn't make sense. Think of it this way: imagine all of these firms walking into a room with $100 each. You lock the door behind them, and allow them to feverishly place bets with each other on anything they want for 24 hours. At the end of 24 hours, you unlock the door and count the money. How much money would be in the room? An average of $100 per firm. One firm could theoretically have all the money, but on the whole, the financial system would be whole. Now, if the government were to walk into that room and say, "You know, this was fun, but we're going to reverse all of the bets you guys placed in the last 24 hours, and you all get to leave the room with what you came in with.", what would be the downside? None, as none of them actually needed the insurance to cover losses they had incurred in the mortgage market. All the betting was just a bunch of nonsense that didn't need to take place, and it can be reversed without any consequences.

The AIG crisis was greatly overblown due to a fundamental lack of understanding by our government officials about the speculative uses of CDS. When AIG melted down, cool heads needed to prevail, and all CDS activities should have been suspended. Speculative CDS trades should have been reversed and the premiums paid for the CDS should have been returned to the buyers. In other words, these speculative CDS trades could have been unwound, with a net loss of zero to the financial system.

To the extent AIG’s CDS were covering legitimate mortgage losses, the government could have made an assessment of whether AIG could make good on those claims, assuming they'd be able to take custody of the underlying mortgages that were insured, and that those would be sold for, say, 50 cents on the dollar. Including the proceeds from those mortgage sales, if AIG wouldn't have had enough capital to cover those legitimate claims, then it should have been put into bankruptcy and the claimants could have been paid some pro rata share of the amount they were due. This would have put the remaining portion of the mortgage losses back onto the books of the banks that were holding the mortgages. The government would then have to deal with those banks' solvency one-by-one.

In reality, the government has allowed AIG to make good on all claims, regardless of whether they were bona fide or speculative. Speculative traders in CDS have walked off with $100 billion in taxpayer money. Goldman Sachs, for example, walked off with almost $13 billion. Worst of all, when AIG paid off these amounts, they didn't force the counterparties (like Goldman) to hand over any mortgages to offset the losses. (Remember, in the insurance business, when an insurance carrier pays a claim, they have a right to take title to the impaired asset.) AIG and the government could have cut the losses in half simply by forcing the counterparties to go into the mortgage market, buy the mortgages covered by the CDS, and turn them over to AIG when AIG paid off the CDS. Why they didn't is just one more example of either incompetence or panic-induced haste at work.

Clearly, this CDS mess is the biggest financial disaster in history. Due to gross incompetence, or even worse--perhaps a conspiracy against the public in favor of Wall Street--we are witnessing the greatest transfer of wealth from the general public to the rich in the history of mankind. What can we do about it? We can still insist on a massive accounting of the speculative CDS positions. Remember, that money has not left the financial system. It's still rattling around the halls of Goldman Sachs and elsewhere. To the extent it went to overseas banks, we probably won't be able to get it back, but to the extent it's within our borders, we have a right to it. It's our money.